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Volatile Mortgage Bonds Behind Collapse of Hedge Fund

April 13, 1994

WASHINGTON (AP) _ The downfall of Askin Capital Management would seem to be a textbook study for regulators and members of Congress worried about the potent brew of two controversial forces in the market: hedge funds and derivatives.

The Askin funds lost $600 million of their clients’ money in recent weeks, chiefly because of a sharp decline in the bond market, published reports say. Askin’s Granite Partners L.P., Granite Corp. and Quartz Hedge Fund filed for Chapter 11 bankruptcy protection last week.

Askin’s legal troubles continued Tuesday as Marion Merrell Dow Inc. sued the firm in federal court in Kansas City, Mo., alleging mismanagement of its investment.

Askin’s plight is expected to come up during the House Banking Committee hearing Wednesday on hedge funds - privately managed investment funds geared for the wealthy.

House Banking Committee Chairman Henry Gonzalez, D-Texas, has asked regulators whether hedge funds, which are largely unregulated, are creating market instability through their highly leveraged bets on bonds, stocks and other investments.

Securities and Exchange Commission Chairman Arthur Levitt Jr., in a letter released late Tuesday, said he shares the concerns of some members of Congress concerning ″the ability of such funds to contribute to volatility in global financial markets.″

However, Levitt said the SEC staff concluded there was no need for new regulation of hedge funds. He endorsed increased data on the funds through a so-called large traders reporting system.

Levitt’s comments, much awaited on Wall Street, were contained in a letter to Rep. John D. Dingell, chairman of the House Committee on Energy and Commerce and Rep. Edward J. Markey, chairman of the Commerce subcommittee on telecommunications and finance. The hearing is just two weeks after the downfall of the three hedge funds managed by David J. Askin, a veteran bond market investor and the company’s president. Askin didn’t return a telephone call.

Rising interest rates set off a chain of events that sharply depleted the value of Askin’s funds, which were heavily invested in mortgage-backed bonds known as collateralized mortgage obligations, or CMOs.

CMOs come under the umbrella of derivatives - financial contracts created by banks and brokerage firms to help corporations reduce the risk of moves in interest rates and currencies. The value of derivatives generally is based on an underlying group of stocks, bonds or commodities.

CMOs come in all varieties, and the riskier class has behaved unpredictably during the recent swings in interest rates. They are mortgage-backed bonds, but they’re sliced up and repackaged in ways to appeal to investors with a stomach for either more or less risk than the original bond.

Some market professionals have been burned in the past two years as their riskier CMOs dropped sharply in value due to prepayment of the underlying mortgages as homeowners refinanced because of falling interest rates.

Askin was a major buyer of the riskiest CMOs, and borrowed $1.4 billion to acquire major trading positions, published reports say. His strategy was to balance different classes of the bonds to make the fund ″market-neutral,″ or stable, despite interest rate changes.

As the value of Askin’s bonds dropped, brokerage firms demanded Askin pay additional money to make up for the reduced value of his collateral, reports say, a practice known as ″margin calls.″

Askin isn’t the first to get nailed in CMO dealings. J.P. Morgan & Co. lost $50 million in the first quarter of 1992 due to a wrong-way bet on CMOs, and Merrill Lynch & Co. lost $377 million in CMO trading in 1987.

However, Askin’s downfall is unusual for the hedge fund industry, said George Van, chairman of International Advisory Group in Nashville, Tenn., who oversees a database of some 800 hedge funds.

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